Who Will Be the Next Hewlett-Packard?

Nov. 30 (Bloomberg) -- During the technology-stock bubble
of the 1990s, it would have been a compliment to say a company
had the potential to become the next Hewlett-Packard Co. That
same line would have a very different meaning now.

Today, if someone called a company the next Hewlett-Packard, this would probably mean it is a prime candidate to
book huge losses because of disastrous acquisitions. What might
such a company look like? Consider Xerox Corp.

At the start of 2007, Xerox had a stock-market value of $16
billion. Since then, the Norwalk, Connecticut-based printer and
copier pioneer has paid about $9.1 billion to acquire 41 other
companies. It has destroyed more value than it created. At $6.79
a share, Xerox’s market value is $8.6 billion -- equivalent to
71 percent of its common shareholder equity, or book value.

The most glaring sign that large writedowns may be needed
at Xerox is a line on its books called goodwill, which is the
intangible asset that a company records when it pays a premium
in a takeover. Xerox’s balance sheet would have investors
believe that its goodwill alone, at $9 billion, is more valuable
than what the market says the whole company is worth.

Xerox’s goodwill obviously isn’t worth that in reality.
Goodwill exists only on paper and can’t be sold by itself. It’s
a plug number, defined under the accounting rules as the
difference between the purchase price for an acquisition and the
fair value of the acquired company’s net assets.

‘Reference Points’

Asked about the possible need for large writedowns, a Xerox
spokeswoman, Karen Arena, noted that the company will conduct
its annual goodwill-impairment test this quarter.

“Share price is just one of several reference points we
use to validate our assumptions,” she said. “We also look to
our operational results, including cash flows, revenue growth
and profit margins.”

Most of the goodwill on Xerox’s balance sheet arose from
the company’s $6.5 billion acquisition in 2010 of Affiliated
Computer Services Inc., a provider of information-technology
services. Xerox allocated $5.1 billion of the purchase price in
that deal to goodwill. Xerox’s latest balance sheet also showed
$2.9 billion of other intangible assets, the bulk of which are
customer relationships acquired from Affiliated Computer.

Suspiciously high goodwill was the same indicator I pointed
to in an Oct. 4 blog post suggesting that more large writedowns
were needed at Hewlett-Packard. The Palo Alto, California-based
maker of computers and printers traded for a significant
discount to book value at the time, and its goodwill exceeded
its market value by $7.5 billion.

Hewlett-Packard last week disclosed an $8.8 billion
writedown of goodwill and other intangible assets from its 2011
purchase of the U.K. software maker Autonomy Corp. It said more
than $5 billion of the charge was related to financial-reporting
improprieties by Autonomy. The disclosure sent Hewlett-Packard’s
shares down 12 percent in a day.

Regardless of whether the allegation proves correct,
Hewlett-Packard paid way too much for Autonomy, which had a
reputation for aggressive accounting long before it was bought.
(Just ask the analysts at the financial-research firm CFRA in
New York, who wrote 14 reports from 2001 to 2010 raising doubts
about Autonomy’s accounting and disclosure practices.)

Hewlett-Packard had allocated $6.9 billion of its $11
billion purchase price for Autonomy to goodwill. The writedowns
disclosed last week were only the latest of their kind. Three
months earlier, Hewlett-Packard recorded a $9.2 billion
writedown largely related to its buyout of Electronic Data
Systems Corp. in 2008.

Dubious Leaders

A search for other companies with strangely high goodwill
values turned up several notable examples. Credit Agricole SA,
the French bank that trades for about a third of its book value,
shows goodwill of 16.9 billion euros ($21.9 billion). By
comparison, its stock-market value is 14.6 billion euros.

Telecom Italia SpA, which trades for about 60 percent of its
book value, has goodwill of 36.8 billion euros and a market
capitalization of only 13.2 billion euros. Fiat SpA, the Italian
automaker, trades for less than half of book and shows goodwill
of 10.4 billion euros -- more than twice its market value.
Nasdaq OMX Group Inc. trades for 78 percent of book and shows
$5.3 billion of goodwill; its market cap is $4 billion.

Those kinds of numbers -- where the balance sheets are
clearly out of whack with market sentiments -- don’t necessarily
mean the companies will be required to slash asset values. But
they are strong indicators that big writedowns may be needed.
The test under the rules ultimately comes down to management’s
cash-flow projections, and whether they are strong enough to
justify the goodwill on the books. That’s why goodwill
writedowns can be an important signal about the future.

Xerox had an infamous accounting scandal more than a decade
ago that resulted in a $10 million fine by the Securities and
Exchange Commission. The penalty was a record at the time for an
accounting-fraud case. Six former executives, including former
Chief Executive Officer Paul Allaire, paid $22 million in SEC
settlements in 2003. The last thing Xerox and its CEO, Ursula
Burns, should be giving investors is a reason to wonder whether
they can trust the company’s numbers.

The market has already decided it has one.

(Jonathan Weil is a Bloomberg View columnist. The opinions
expressed are his own.)